Why Putting Everything into Your Mortgage is Risky

-- Moderation in all things
 

-- Avoid extremes
 

-- Don’t put all your eggs in one basket
 

These are some of the lessons we grew up with and, hopefully, have served us well. Happily, the same advice mom taught us also comes in pretty handy when managing our assets and liabilities – specifically houses, investments, and mortgages. 

There are two extremes when it comes to mortgages and the use of financial leverage. One extreme is to use the smallest down payment you can, borrow as much as you can, and after you have paid your mortgage and other bills, invest all your extra funds as aggressively as you can. Then, if your house appreciates in value, borrow more on a second mortgage and invest that as well.

The idea behind financial leverage is to borrow low with your mortgage and invest high in the financial markets. For example, if your mortgage is 5% and your stock portfolio returns 8%, you have profited from financial leverage to the tune of three percentage points. The more aggressive your investments, the greater the potential return. But what if you take too much risk and your investments crash? You can still hang on to your house as long as you can make the payments. But what if you lose your job, too? Since you have lost your savings and now have no income, sadly you will also be losing your home. 

Okay, so using leverage is not for you, you say. There is no way you want to put your house at risk. So the safest thing is to go to the other extreme. You want to get as far away from leverage as possible. This will be the safest route, right? Well…

The opposite extreme to maximum financial leverage is to use all of your savings to make your largest possible down payment and then add as much as you can to your mortgage payment each month. The goal is to pay off your house as fast as possible. However, at this extreme, you are putting all your eggs into one basket. You have absolutely no diversification and, unfortunately, this also leaves you exposed to the risk of losing your home. Here’s why: 
 

• We are only five years removed from the burst of the housing bubble. Yes, we learned that it isn’t only the financial markets that can tank. When house prices dramatically fell, many home owners were left owing more on their homes than they could sell them for (this is called being underwater). This was not a problem for those who were dug in and had no plans to move, but those who had to sell were hit very hard and realized large losses. Those who had elected to put everything they had into their mortgages and therefore had no retirement savings, no education savings, and no emergency savings (if you have a mortgage AND any type of savings, you are using financial leverage) were hit especially hard as they had nothing to draw upon to cover their losses.

• You don’t need a bubble burst and ensuing recession to lose your job. Throughout history, new technology has displaced workers as new and better ways of doing things were created (these days with high technology it can happen at lightning speed). Buggy whip makers lost their jobs when the automobile was invented; Pony Express riders lost their jobs when the telegraph was invented; tens of thousands of secretaries lost their jobs when the desk top computer was invented; and our entire world economy was restructured during the internet boom of the 1990s. The moral of the story is that few jobs are safe. There will always be new technologies and new industries replacing the old. Those who put everything into their mortgages are especially at risk since losing a job will mean no income AND no savings from which to make mortgage payments while they look for, or train for, a new job.

The key to success here is to avoid both of these extremes (moderation in all things). The safest strategy is to employ prudent amounts of leverage, at least enough to fund a retirement plan and emergency savings. Do not wait until your mortgage is paid off before you start saving. You may need to use these funds to stay in your home. 

Fortunately, you don’t have to take my (your humble Prof. M. Max) word alone. Here is what the professional journals have said about the use of financial leverage (excerpts compiled by ricedelman.com):

Thus, a homeowner with a long time horizon and a willingness to assume some risk will likely have a much higher net worth than someone who selects the less risky option of the 15-year mortgage. 
 

--  The Effects of Income Tax Rates and Interest Rates in Choosing Between 15- and 30-Year Mortgages. The CPA Journal #65, 1995.
 

… home owners may not be adequately considering the opportunity costs of the investment in their home. Individuals should not attempt to analyze the mortgage decision in isolation from their overall personal financial plan. Instead they should consider the mortgage decision along with their plans for long-term investing, insurance needs, tax planning and so forth. If the only way home buyers can afford the higher 15-year mortgage payment is by delaying long-term investments or by limiting the funds they commit to a long-term investment plan, they may be better off in the long run by taking the 30-year mortgage with the lower payment and investing the difference... the 30-year mortgage is clearly the best financial choice for many home buyers. 
 

--  15-Year Versus 30-Year Mortgage: Which Is the Better Option? Journal of Financial Planning, April 1998.
 

Planners must consider many factors when analyzing the 15-year versus 30-year mortgage option, but certain issues deserve mention. First, even if the mortgage is held to maturity, the argument that the 15-year option is optimal because fewer total dollars are spent to purchase the home is seriously flawed. The fact that a smaller total dollar expenditure is required for the 15-year loan is irrelevant to the maturity decision. 
 

--  Including a Decreased Loan Life in the Mortgage Decision Journal of Financial Planning, December 2003.
 

Advantages of the 30-year mortgage include lower monthly payments and accumulated wealth, in an investment account available to help alleviate hardships. Withdrawals from the investment account would be free of penalties for the non tax-deferred accounts, and free of penalties for the tax deferred….The data showed that a borrower…willing to invest with a risk level associated with the S&P 500 would benefit from a 30-year mortgage. 
 

--  Effect on Net Worth of 15- and 30-Year Mortgage Term. Journal, Association for Financial Counseling and Planning Education, 2004. 
 

The popular press, following conventional wisdom, frequently advises that eliminating mortgage debt is a desirable goal. We show that this advice is often wrong…mortgage debt is valuable to many individuals. 
 

--  Mortgage Debt: The Good News. Journal of Financial Planning, September 2004.
 

Better financial results accrue to some borrowers when they select a 30-year mortgage coupled with a simultaneous investment plan rather than a 15-year mortgage term and a subsequent investment plan…for the vast majority of borrowers, there remains a significant probability that the 30-year mortgage is the better mortgage product even in higher mortgage rate scenarios. Further, the financial benefit associated with a 30-year mortgage increases as the borrower’s marginal tax rate and risk tolerance increase. 
 

-- Is a 30-Year Mortgage Preferable to a 15-Year Mortgage? Journal, Association of Financial Counseling and Planning Education, 2006, Volume 17 Issue 1.
 

… U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice…in the aggregate, these mis-allocated savings are costing U.S. households as much as $1.5 billion dollars per year. 
 

--  The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings. Federal Reserve Bank of Chicago, August 2006. 
 

In future posts, I will be talking about risk and return (and how understanding this simple but powerful principle can help you identify scams), the risk reduction qualities of diversification, and why your house should not viewed as a retirement asset. Stay tuned.

MM

 

What About All Those Ads Telling Me to Buy Gold?

From the beginning of time, gold has been a valuable commodity and probably always will be. It can be a good hedge against inflation and I wouldn’t be against having up to 5% of my portfolio in gold for that reason. But historically it is one of the worst performing assets. This is because gold pays no interest, no dividends (and therefore cannot provide the all-important compounding of reinvested interest and dividends) and creates no business value.

The only way to profit from gold is to time the market. In other words, you are relying on the greater fool theory. Yes, you may be a fool for buying at $1,000 an ounce but if there is an even bigger fool who will take it off your hands at $1500, you still make money. But how many fools are out there? (Actually, quite a few, but I digress.) How high can the market go? The trick here is to avoid being the greatest fool of all, the one who buys at the very top of the market.

Gold has been rising over the past few years because gold is viewed as a safe haven and there have been fears of everything from economic collapse to hyperinflation (more buyers than sellers drives up the price). When prices keep going up and up and up, we call this a bubble. If you recall, we had one of these recently in real estate (and stocks in the late 90s). Bubbles are not anything new. We seem to have a bubble of some kind about once every decade. Ever since the tulip bulb crisis in the late 1500s (probably the earliest bubble on record), there have been booms and busts in just about everything.

While millions have been made from trading commodities and collectibles, the financial law of gravity always seems to prevail -- eventually. The key is to know when eventually is going to take place. This is no small task!

Just keep in mind that when dealing with precious metals and other commodities and collectibles, you have left the realm of investing and entered the world of speculation. As long as you understand the risks and do not spend more than you can afford to lose, hey, you never know, you may hit a home run. But if you strike out, well, maybe you had some fun, but more importantly, you still have your nest egg.

MM

Addendum: See this excellent New York Times article: http://www.nytimes.com/2013/07/28/business/budging-just-a-little-on-investing-in-gold.html?smid=pl-share&_r=0



 

Wisdom from Saturday Night Live

(If only our politicians were this wise)

http://screen.yahoo.com/dont-buy-stuff-000000884.html


 

Are Credit Cards Good or Bad?

Are credit cards good or bad? That’s like asking if fire is good or bad. If the fire is keeping you warm and cooking your food, then fire is GREAT! But if it is burning your house down ... well, maybe not so much. The same is true of credit cards. If kept under control, there are many benefits to credit cards, but if credit cards are controlling you, they will burn you alive.

The costs of credit card use are well known because so many people have allowed their credit cards to burn uncontrolled. They succumb to the 'minimum payment' rouse and buy whatever their hearts desire and before they know it they are thousands (sometimes tens of thousands) of dollars in debt. The once manageable minimum payment has grown to be a serious burden and at high interest rates can take decades to pay off.

However, with careful and wise oversight (i.e. no gas poured on the flame) credit cards can really be a great way to make purchases. The catch: YOU MUST PAY OFF THE ENTIRE BALANCE EACH MONTH AND PAY IT ON TIME! If you don’t pay off the entire balance you will be hit with high interest charges. Even if you pay off MOST of the balance, credit card companies have this funky way of determining your average balance (skewed heavily in their favor, of course) and will still charge a lot of interest. If your payment arrives even a day after the due date, you will be charged an atrocious late fee.

So why bother with a credit card if you have to be so careful not to get slaughtered by interest, fees and penalties? First of all, you can earn cash back and other benefits such as free airline flights and roadside assistance. Also, it is often the case that credit cards will insure goods purchased against theft or malfunction (but you have to remember that you have this insurance. My son had a portable hard drive stolen out of his backpack at the airport -- we think a TSA employee slipped it into his pocket -- and we forgot that the insurance provided by our credit card covered that. We eventually did remember, but not until after the three month deadline had passed. These benefits are not of much value if you forget that you have them). Credit cards are also a great way to travel and to keep track of expenses. It is all right there on the statement. And, of course they can be helpful in an emergency -- especially if you are away from home (some credit cards even offer concierge services).

Why do credit card companies provide all these kickbacks and where does the money come from? The money comes from the stores where you make your credit card purchases. They pay a fee to the credit card company to process the payment (the reason some places do not accept American Express is because their fee is higher than most other cards). When the credit card gives you your reward, they are essentially sharing part of this fee with you.

Some retailers charge a higher price if you use a credit card (I have seen this at gas stations from time to time) to pass along this fee to the customer but this is rare. Most of the time, credit card users pay the same price as those who pay with cash. Given that this is the case, it makes sense to make all of your purchases with a credit card so you can take a free flight now and then. BUT AGAIN, ONLY IF YOU PAY OFF THE ENTIRE BALANCE AND PAY IT ON TIME! Otherwise this will all backfire (that is, the flame becomes unmanageable and begins to burn your house).

HOWEVER, there is a very important downside to this strategy. With purchasing power always so convenient, it is human nature to spend more with a credit card than would have been spent with cash (or a check/debit card). Even with the commitment to pay off the entire balance and pay on time, it is all too easy to stop at a whim to buy that slice of pizza or tank of gas for a last minute trek out of town. This is where you have to be careful to keep your spending under control. It is in those weak moments that you can get into trouble where using cash or check/debit card may not. So in addition to paying the entire balance and paying on time, we need to add another requirement for making credit cards work for you: NEVER BUY ANYTHING YOU WOULD NOT HAVE PURCHASED WITH CASH.

Credit cards are especially hazardous for college students. Many students have gone down in flames from excessive credit card debt, sometimes even having to drop out of college. Again, BE CAREFUL. YOU ARE PLAYING WITH FIRE!

As always, there are costs and benefits to everything. Like fire, credit cards can be high risk. If you can’t handle them properly, don’t use them. (Psst, most people can't handle them)

The links below take you to a special section in Business Week magazine that talks about credit card problems and shady marketing practices used by credit card companies to get college students hooked. This is fire indeed!

Majoring in Credit Card Debt

Confessions of a Credit Card Pusher

The Dirty Secret of Campus Credit Cards

MM

 

Now What Do I Do?

I don’t remember ever having been asked so many questions about the economy as I have over the past few years. Of course, as a professor of economics, I am accustomed to the occasional “where should I invest my money?” but the recent meltdown and feeble recovery has everybody asking what in the world is going on? For those who are really interested, I would encourage them to enroll in a macroeconomics course. However, there is much to be said that doesn't require graphs and equations. In a nutshell, this is what I am telling my students and others who ask.

First of all, expansions and contractions are inherent in a market based economy (regardless of who is in office). We put up with these fluctuations because market economies produce greater innovation and higher standards of living than the alternatives. Fortunately, we have roughly seven years of expansion to one year of contraction. The down side is that market economies are not very forgiving of reckless behavior. And, oh, have we been reckless! We are a nation with a badly inflated sense of entitlement, living far beyond our means with the expectation that someone will bail us out when our frivolity boils over. Individuals, families, and government all spend more than they bring in, and we are now seeing some of the fallout from such irresponsibility.

The solution is simple but unpleasant: We need to become a responsible people:
 

• Cut up the credit cards if you can’t handle them and get rid of the cell phones if you can’t afford them. Drive cars and live in houses that leave you with enough to save 10-15% (including employer contributions) of your income for retirement. And speaking of retirement, Social Security was never meant to be more than a supplement. Spending like a drunken sailor (my sincerest apologies to drunken sailors) with the belief that Social Security or any other government program will swoop in to save you will result in very lean “golden” years.

• Get all the education you can. In a highly competitive global economy, education is the key to survival and success. Good jobs that require physical strength are diminishing. Brain power is where the future is. Learning how to learn is your most important skill. Updating job skills and even changing careers is often necessary in these days of rapid technological innovation. Be flexible; it will probably be necessary to relocate a time or two.

• Plan on working into your 70s. With increasing life expectancies, 65 is awfully young to retire. Even with the best planning, you risk running out of money if you retire too soon (keep in mind that medical and custodial costs can be enormous in the last few months/years of life -- between $4,000 and $10,000 a month depending on where you live and the level of care). It would help to find a career that you love. The more education you obtain, the more likely you will be able to achieve this.

• Use debt only for the following: 1) house, 2) education, 3) automobile. But be prudent in all three. Avoid as much student debt as possible. Get a part time job and work your way through college. Drive a used car and do not over extend yourself on the house you buy. Even in the aftermath of the housing bubble, you may still qualify for a loan that exceeds what is prudent (do understand that real estate agents and loan officers are not financial advisors). And despite aggressive (and sometimes unscrupulous) lenders, the borrower bears the responsibility of studying and understanding all of the terms of the contract.

Financial and economic illiteracy is an enormous problem in our nation and has had devastating consequences. A tragically large proportion of our citizens (including an alarming number of politicians) do not understand even the most basic economic principles. Become a student of personal finance. Learn about prudent investing. Understand the relationship between risk and return. Understand the importance of insurance and have the right kinds and right amounts of insurance. Learn about taxes and retirement planning and estate planning. There are many good books on these subjects. Do not simply leave it to brokers and agents. Whatever your field of expertise, you need to know something about financial and risk management.

The bottom line is to be responsible and accountable. You put yourself in great danger of sabotaging your future by engaging in risky and self-destructive behaviors (e.g. drug abuse, alcohol abuse, sexual promiscuity, and … too much debt!). Learn to say no to enticing advertising and credit card offers. You are the one who is in control of your life -- live like it. Take advantage of the opportunities that are before you. Work hard and think big. Most of all persist and persevere. There will be many challenging and painful times in your life. Be tough and power through them -- responsibly.

MM

 

The Purpose of this Blog

I have been thinking of starting a blog for a few years now. Why? Certainly not for fame or fortune (like that is going to happen) but for my kids. I have now taught undergraduate finance and economics for 24 years and have volumes of lecture notes, mini-lectures for online classes, plus a few articles I have written. But unless my kids are also my students, colleagues, or members of the community who happen to catch me in an occasional TV or radio interview, the knowledge I have gained over the years will be, to a large extent, lost on them. MY VERY OWN KIDS!  And this is important stuff to know. Understanding basic concepts of economics and finance can make an enormous difference in the quality of our lives. It can create opportunities that otherwise would not have been available. It can also keep us from doing some really dumb things; things that can take years to overcome.

Research by The National Endowment for Financial Education concludes “that a large percentage of people of all ages, incomes and education levels lack the basic financial knowledge and skill to ensure long-term stability for themselves and their families.” The study goes on to say that “inappropriate financial decisions can have long-term negative effects and national consequences will result from a continued lack of financial literacy.”

National consequences? Was that prophetic or what!!! We are still bearing the burden of the mortgage meltdown. It began with people buying houses that they could not afford (which amazingly was encouraged and enabled by government policy) and when mortgage defaults placed those homes back on the market, prices began to fall. This kicked into gear a decline in economic activity that eventually resulted in the worst recession since the 1930s and the highest unemployment since 1982!

Financial illiteracy truly is one of this nation's most pressing problems. Individuals, families, and government all spend more than they bring in. People live in houses and drive cars they cannot pay for. Too many get into credit card debt and are never able to dig themselves out. Those who are able to dig themselves out are often not able to save enough for retirement. Others lose their retirement savings in investments they do not understand, having taken risks they didn't know existed. Financial illiteracy takes an enormous toll!

Yes, my kids have heard me talk about this over and over again, but I want them to have a written reference (with the hope that being online might make it hip enough to actually read). So, here it is. This blog is dedicated to the financial literacy of my children, David, Sarita, and Daniel.

Everyone is Welcome

While my kids are my primary motivation here, if others happen to stumble in that is okay too. Welcome aboard! It is a pleasure to have you with us. This blog will include random "deep" thoughts and musings about a wide range of financial and economic issues. The more the merrier.

Why Mad Max?

It’s a nick name given to me by Paul Solman, the business and economics correspondent for The PBS News Hour. I worked with Paul on some videos a few years back (distributed with McGraw-Hill/Irwin economics textbooks and also available at Amazon.com). He was amused by my email address, maxutils (which is short for maximize utility, a reminder that this is everybody’s objective function. Yes, a rather staid inside joke among economists, ha ha). Anyway, Paul started calling me Max and later Mad Max. I always kind of liked it and it seemed to fit (even though I don't think I am actually mad -- at least not yet)

Why 1776?

First and foremost it was the year of the Declaration of Independence here in the United States, and if there is anything I want to be associated with personal finance, it is INDEPENDENCE! But 1776 is also known for something else very significant, something that took place across the Atlantic in Scotland and would also have an enormous impact on the world. It was the year that Adam Smith gave birth to modern economics with the publishing of his revolutionary book: An Inquiry into the Nature and Causes of the Wealth of Nations.

About Mad Max

I am but a meek and lowly professor of economics. Over the years, I have taught courses in corporate finance, international finance, investment management, personal finance, financial markets and institutions, microeconomics, macroeconomics, and modern economic issues at colleges and universities along the east coast from Florida to New York. In addition to maximizing my utility, my objective function is to just try to do more good than harm and stay out of trouble. Not an easy proposition in my experience :)

MM